Both Treasury’s report and the conference showed that there’s still important debate about the potential merits and demerits of a continued government backstop in the prime mortgage market. Treasury’s three options, for example, run the gamut from no guarantee to a backstop guarantee that kicks in during bad times to a permanent, broad-based guarantee. I’ll have more to say on these options in the future.

For now, I’d like to highlight several other aspects of the Treasury report and the discussion at Brookings that I found encouraging. Based on what I heard (and what I read between the lines of the Treasury report), there appears to be near-consensus on five important issues:

The multi-trillion dollar investment portfolios of Fannie Mae and Freddie Mac were a mistake. As the Treasury report puts it: “Fannie Mae and Freddie Mac were allowed to behave like government-backed hedge funds, managing large investment portfolios for the profit of their shareholders with the risk ultimately falling largely on taxpayers.” Such government-backed portfolios have no place in our future mortgage finance system.

Any future government assistance must be better targeted. For example, the conforming loan limit (and its FHA counterpart) need to come down.

If there are any future government guarantees for prime mortgages, they must be protected by greater private capital.

If there are any future government guarantees for prime mortgages, they must be explicit, and financial firms must pay at least actuarially fair rates to purchase them.

Affordable housing programs should be transparent and on budget, rather than embedded in regulatory requirements on Fannie Mae, Freddie Mac, or any successors.

Each of these would be a substantial improvement from the old GSE system.

Yesterday, the Congressional Budget Office released its long-awaited report on the future of Fannie Mae and Freddie Mac. Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market (written by Deborah Lucas and David Torregrosa, with input from a cast of dozens — including, full disclosure, me as an outside reviewer) provides an outstanding overview of Fannie and Freddie’s history, the arguments for and against a government role in the secondary mortgage market, the flaws of the precrisis structure of Fannie and Freddie, and the pros and cons of possible reform models.

Readers may recall that last spring Phill Swagel and I proposed a reform in which Fannie and Freddie would be privatized, the government would sell guarantees on mortgage-backed securities composed of conforming loans, and that this guarantee would be available not only to Fannie and Freddie but also to qualified new entrants. (Here’s the blog version; here’s the full paper.)

CBO provides a thoughtful overview of such hybrid models:

A Hybrid Public/Private Model

Many proposals for the secondary mortgage market involve a hybrid approach with a combination of private for-profit or nonprofit entities and federal guarantees on qualifying MBSs. At its core, the hybrid public/private approach would preserve many features of the way in which Fannie Mae and Freddie Mac have operated, with federal guarantees (combined with private capital and private mortgage insurance) protecting investors against credit risk on qualifying mortgages. However, most hybrid proposals would differ from the precrisis operations of Fannie Mae and Freddie Mac in several important ways: A possibly different set of private intermediaries would participate in securitizing mortgages backed by federal credit guarantees, the guarantees would be explicit rather than implicit, and their subsidy cost would be recorded in the federal budget.14 As the public-utility and competitive market-maker models illustrate, a hybrid approach could be implemented in a way that involved more or less federal regulation of participants in the secondary market and a smaller or larger number of competitors in that market.

Advantages of a Hybrid Approach

Regardless of its exact design, a hybrid model with explicit federal backing for qualifying privately issued MBSs would have several advantages over the precrisis model, as well as over either a fully federal agency or complete privatization (approaches that are discussed below). An explicit federal guarantee would help maintain liquidity in the secondary mortgage market, in normal times and particularly in times of stress, and could retain the standardization of products offered to investors that Fannie Mae and Freddie Mac bring to that market. Compared with the precrisis model, imposing guarantee fees would ensure that taxpayers received some compensation for the risks they were assuming.

Compared with a fully federal agency, a hybrid approach would lessen the problem of putting a large portion of the capital market under government control, encourage the inflow of private capital to the secondary market, and limit the costs and risks to taxpayers by having private capital absorb some or most losses. Putting private capital at risk would also provide incentives for prudent management and pricing of risk.

Compared with a fully private market, hybrid proposals would give the government more ongoing influence over the secondary market and an explicit liability in the case of large mortgage losses that would be reflected in the budget. That arrangement might have the advantage of leading to a more orderly handling of crisis situations.

Disadvantages of a Hybrid Approach

Relative to other approaches, a public/private model has a number of potential drawbacks, the importance of which differs depending in part on the specific design chosen. Experience with other federal insurance and credit programs suggests that the government would have trouble setting risk-sensitive prices for guarantees and probably would shift some risks to taxpayers. A hybrid approach also might not eliminate the tensions that exist—with regard to risk management and pursuit of affordable housing goals—between serving private shareholders and carrying out public missions.

Another concern is that over time, the secondary-market entities might push for broader guarantees of their product lines and attempt to reestablish themselves as too-big-to-fail institutions backed by implicit federal guarantees. Consequently, regulators would need to be vigilant to control risks to the financial system and avoid regulatory capture, while also being open to market innovations.

The Economist asked several experts to recommend options for resolving Fannie Mae and Freddie Mac, the two failed mortgage giants.

In addition to comments, the magazine’s web site allows users to recommend responses they like. It’s hardly scientific, but since the rankings (as of 9:15pm eastern time) work to my favor, let me rank them in declining order of recommendations:

My co-author Phill Swagel (a whopping 13 recommendations) describes our joint proposal for fully private GSEs that purchase an explicit backstop from the government for their mortgage-backed securities. Pros: The relationship is explicit and transparent, taxpayers are compensated for bearing risk, the portfolios are eliminated, the government backstop will soften severe mortgage meltdowns, and competition can discipline the Fannie and Freddie duopoly. Cons: There are still risks from the remaining government role.

John Makin (7 recs) wins the award for brevity, arguing that they should be liquidated over 5 years.

Mark Thoma (4 recs) suggests a continued role for the firms, as long as they face much tighter regulation.

Tom Gallagher (4 recs) proposes putting them back on the federal budget as real agencies. This avoids some potential pitfalls of having them run as private companies.

P.S. As an anonymous commenter helpfully points out, the entries over at the Economist have these newfangled things called “dates” associated with them. Not sure how I missed that. The two highest scorers are also the oldest. Also, I must confess that I clicked the recommend button on Phill’s piece, lifting it to 14 votes. Because of some weird interaction between Safari and the Economist site, however, that resulted in it believing that I recommended all five pieces. Ah the perils of technology.

[Their plan would] abolish the most toxic features of the old “government-sponsored enterprise” model. In particular, the plan would get Fannie and Freddie out of the business of directly purchasing mortgage-backed securities, which was highly profitable to them in large part because their implicit government guarantee enabled them to fund a large portfolio at artificially low rates. Their existing $5 trillion pile of securities and guarantees would be wound down or sold off to the private sector.

But Mr. Marron and Mr. Swagel would keep a government role in Fannie and Freddie’s other business: securitizing conventional, moderately sized “conforming loans,” which is both necessary to mortgage liquidity and relatively less risky. And instead of a non-transparent, implicit government guarantee, the new securities would carry an explicit one, for which the securitizers would pay a fee. Accumulated fees, in turn, would cover losses, thus shielding taxpayers. To promote innovation and competition, this business would be open not only to Fannie and Freddie but to any other well-capitalized financial institution capable of taking it on.

The past few years have demonstrated that Fannie Mae and Freddie Mac, the two mortgage giants, were built on a flawed business model. One that paired private profit in good times with taxpayer burdens in bad times; created systemic risks to the world financial system; concealed the degree of federal involvement in mortgage markets; and directed many of the benefits of government assistance to shareholders and management, rather than homeowners.

The folks at e21 asked Phill Swagel and me to ponder how Fannie and Freddie ought to be restructured when they emerge from government conservatorship.

The two firms would become private companies that buy conforming mortgages and bundle them into securities that are eligible for government backing. The reformed firms would not have the investment portfolios that were the main source of risk under their previous structure. The federal government would offer a guarantee on mortgage-backed securities composed of conforming loans. This guarantee would be explicit, backed by the full faith and credit of the United States. To compensate taxpayers for taking on housing risk, Fannie and Freddie would pay an actuarially fair fee to the government in return for the guarantee, and the shareholders of the firms would take losses before the government guarantee kicks in. Other private firms such as bank subsidiaries would be allowed to compete by securitizing conforming loans and purchasing the government guarantee. Over time, entry into these activities would help ensure that the benefits of the government support are passed through to homeowners and would reduce the risk that the failure of any one firm would pose a threat to the housing market or the overall economy.

Our proposal would also free Fannie and Freddie from regulatory requirements that promote affordable housing. As worthy as those efforts can be, we believe they should not be run through these reformed organizations with their narrower missions (and no investment portfolios). If policymakers think that the conforming mortgage market should help finance those efforts, that can be done through a tax on the MBS guarantees, above-and-beyond the actuarially-fair fee for the government insurance. The resulting revenue can then be directed to affordable housing programs through usual budget channels.

How did we come to this proposal? Well, we were trying to fix what we see as the major flaws of the old model (lack of transparency, uncompensated taxpayer risk, misalignment of incentives), while maintaining its benefits (e.g., that mortgage credit kept flowing for conforming loans even during the depths of the crisis and that government-insured MBS are a useful asset class when the Fed wants to do quantitative /credit easing). In addition, we felt that some backstop role for the government is inevitable as a matter of political economics and that it ought to be explicit at the outset.

Disclosure: I do not have any positions, long or short, in any Fannie or Freddie securities. Also, a close relative once served as a board member of one of the companies, but that ended several years ago.

The federal government racked up a $389 billion deficit during the first three months of the fiscal year (October through December), according to estimates released by the Congressional Budget Office yesterday. That’s $56 billion more than during the first quarter of last year, almost a 17% increase. (A portion of that increase is due to the timing of weekends and holidays, but even controlling for those, the deficit is up 8%.)

Two factors have been driving the increase:

1. Tax revenues continue to plummet. Revenues fell to $489 billion during the quarter, down $58 billion or 11% from last year.

2. Spending continues to grow rapidly in most programs. For example, Medicaid has grown by 25% since the same period last year, Medicare spending has grown by 8%, and Social Security spending has grow by 10%. After declining last year, interest payments are now on the rise, up more than 17%. Excluding the three programs most closely related to the financial crisis (TARP, the GSE bailout, and the FDIC), federal spending is up about 13% over the same period last year. (All these figures have been adjusted to control for timing differences due to weekends and holidays.)

The one piece of good news, budget wise, is that spending on the three financial programs has declined significantly. CBO estimates that TARP spending during the first quarter fell by $85 billion (from $91 billion to $6 billion), and spending on the GSEs fell by $1 billion (from $14 billion to $13 billion). Net spending by the FDIC fell by $45 billion, primarily because FDIC receipts have increased sharply (and are accounted for as a reduction in spending). Together, those three programs have cost $131 billion less than at this point last year.

Bottom line: Tax revenues continue to fall, most types of spending continue to increase, but spending on the financial rescue has declined.